Many forex traders routinely assess the risk-reward ratio on individual trades they contemplate taking and some even incorporate criteria based on this measure in their trade plans.

Determining the Risk-Reward Ratio on a Trade

To perform a risk-reward ratio calculation in its most simple sense for a particular forex trade, you would just calculate the number of pips from your entry rate until your stop-loss level and compare the result to the number of pips until your projected take profit level.

In general, a risk-reward ratio of 1:2 means that you would risk one pip of loss to potentially earn 2 pips.

To provide a general guide, most successful traders will not enter a trade unless the risk they foresee for it is less than half of what their anticipated reward will be. This means they have a 1:2 minimum Risk/Reward Ratio criterion for any trades they will consider entering.

Basically, having your risk be less than your potential reward on prospective trades is one of the recipes for successful money management over the long term when trading forex.

The Risk-Reward Ratio for Your Overall Forex Trading Business

In order to gain a suitable assessment of the business risks that you may face when trading forex, you can perform a more advanced form of risk/reward analysis.

The steps to go through when performing such an analysis might go as follows:

Step #1 - Research Possible Risks -

You will first need to do enough research into your new forex trading business so that you can effectively foresee any potential risks that may arise.

Step #2 - Estimate Potential Losses and Rewards

Now reasonably determine the potential financial loss that you might incur as a result of the risks you foresee as possible coming to pass. Also compute the potential financial rewards that you hope to earn from forex trading.

Step #3 - Probability-Weight Potential Losses and Rewards

An optional step would be to weight each risk and reward by your best estimate of the probability of it actually occurring in your particular situation to get a set of probably-weighted potential losses. You can then sum these weighted losses up to get a total loss number and can do the same with the weighted rewards.

Step #4 - Compare Risks to Rewards

Now look at the sum of the weighted or un-weighted potential losses and compare it to the sum of the weighted or un-weighted potential rewards. This will give you a risk/reward ratio that you can use to see if your forex trading business makes sense.

Basically, after performing a probability-weighted risk/reward assessment for your forex trading business, you should see a substantially higher chance of success, preferably by a factor of at least two, than your chances of loss.

If not, then be sure to ask yourself why would you want to enter such a risky business in the first place since your time might be better spent elsewhere.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.